Post Retirement Options for Funds
Doing nothing is not an option
The purpose of retirement saving is ultimately to provide a degree of financial security in retirement. The structure of the offering to pre-retirees has been quite well defined by the superannuation industry (albeit, well defined does not mean correct, but that is another debate). However, partly as a function of the relatively small size of the post retirement market, the structure of the offering to retirees is still in its infancy particularly for the non-retail/nonadvice market.
With the value of post retirement assets likely to grow markedly in the coming years and as an explicit requirement for trustees to consider under a MySuper offering, it will be necessary for funds to define more clearly their post retirement options for members.
As we can see above, the post retirement market for non-retail (industry, corporate and public) funds is expected to more than double as a proportion of the total superannuation market over the next 15 years and aggregate retirement assets are expected to represent more than a third of the total superannuation asset pool. Given the underlying growth in the superannuation system, this equates to an 8 fold increase in the dollar value of post retirement assets for non-retail funds. It is therefore imperative that funds develop options for what will become a significantly larger part of their membership and asset base.
However, developing options for post retirement members requires much more than just a new range of member investment choice options. In order to optimise post retirement income, members need to take account of a much wider range of issues including non-superannuation assets, age pension, tax, liquidity and income requirements. This means that some level of tailored advice forms an important part of the post retirement framework. Against this we need to balance the scalability, accessibility and quality of advice that is available, along with the degree of complexity that funds can realistically administer. In short, advice is important but we also need to make sure that members’ retirement incomes are as protected as possible from poor decision making. This will be increasingly important where the level or quality of advice is lower (an outcome that is more likely in a scaled advice framework).
The majority (over 90%) of the superannuation assets that are currently used to provide a retirement income stream are invested via an allocated pension. Allocated pensions are effectively vehicles through which the retiree takes the investment and longevity risk and manages the drawdown process (within limits) themselves. Additionally, about 5% of superannuation assets are used to purchase term annuities (a figure that in recent years is increasing). Term annuities provide a guaranteed payment over a defined period irrespective of mortality – i.e. they are a capital drawdown bond. Traditional life annuities currently make up less than 1% of post retirement assets.
The underlying investment structure of an allocated pension is generally built around the same structures that are currently the mainstay of pre-retirement options. One large industry fund retains its balanced fund as the default options for members up to age 75 at which point it moves to the conservative balanced option which is also a preretirement strategy. While allocated pensions are really just an administration vehicle, even term annuities and life annuities could be unbundled by funds into their component parts. For non-retail funds this is likely to result in a better deal for members than fully bundled options from traditional life insurers (and lower credit risk) for a number of reasons:
- The bundling process allows significant costs to be hidden within the structure. For example Rice Warner’s Superannuation Fee report estimated the embedded costs of traditional annuities at circa 1.7%p.a. and allocated pensions at 1.86% p.a. This compares with pre-retirement total costs for non-retail funds of circa 1% p.a.
- A large part of any individual retail strategy is marketing and distribution costs. Superannuation funds can more accurately target the relevant market segments with substantially lower costs given their ability to target a wider spectrum of their membership base.
- A “best of breed” approach to unbundling allows for a reduction in the costs of individual components and the aggregation of risks (e.g. group life vs. individual life).
- Single issuer products have potentially considerable credit risk with the issuer. The longer the term of the product the greater the potential credit risk (there is no “insurer of last resort” for annuities in Australia).
Put another way, the introduction of competition into the post retirement market and the ability for lower cost providers to participate in the part of the value chain where they have the greatest competitive advantage should provide an important avenue to increase the value of retirement income streams for members and better diversification of credit risk. This is an area where further research could be undertaken by the industry – both to demonstrate the value that can be added through further competition but also the incremental value to Australian tax payers from increasing contributions and generating better post retirement income streams.
Determining the most effective options that funds could offer retirees requires some analysis as to the specific implications of different alternatives. In two prior papers we have addressed these issues in some detail1 . In particular we discussed the issues from a retiree’s perspective of a fully insured, partially insured or uninsured solution. An extract of the relevant section is included in the Appendix.
Broadly there are several problems to be addressed by funds in constructing post retirement options:
- By not segregating post-retirement asset pools from pre-retirement asset pools the differing tax treatment is not being considered, resulting in potentially sub-optimal outcomes.
- The risks to retirees from investment return fluctuations significantly exceed those for pre-retirees as the opportunity to continue in employment (however unpalatable) in many cases does not exist.
- Path dependency of returns in the drawdown phase can lead to very poor outcomes even if “average” returns are achieved over the investment period.
- Target date or life-cycle funds which aim to de-risk members as they approach retirement sound great in the marketing literature, but more often than not result in worse outcomes compared to a simple balanced approach.
- The interaction effects of the age pension, taxation, other non-superannuation assets and the overall level of the retirement benefit all mean that there are an infinite number of potential solutions for any one individual. This makes the generation of simple post-retirement products significantly more complicated than in the preretirement stage.
What’s wrong with pre-retirement options?
The existing model for pre-retirement investment is largely predicated on a broadly fixed strategic asset allocation. This model implicitly assumes that a) the level of growth assets (equities) is a reasonable proxy for risk, b) equities will outperform bonds over the medium term and c) the difference in risk between equity and bond returns is sufficient to warrant holding a substantial exposure to equities at all times.
This assumption though has been severely tested over the last 2 decades. In fact, contrasting the realised efficient frontier of the 1980’s with that of the 1990’s and 2000’s, a very different picture emerges. In the charts below we show the realised efficient frontier for a portfolio of Australian equities and fixed interest over the 1980’s and the 1990’s/2000’s. For simplicity we have identified 3 portfolios of 40:60 (40% equity:60% bonds), 60:40 and 80:20 to reflect varying risk profiles.
The nature of the accumulation and deccumulation process is such that the capital value on which returns are earned is not static. However, the process by which our industry assumes, models, measures and reports investment returns is based on time-weighted returns (i.e. a traditional geometric return). Time weighted returns assume the capital value is static. This is very useful in the context of considering an aggregation of members and measuring say the performance of a particular strategy over time, however it is not that useful for individual members as individuals earn money-weighted returns.
To illustrate, consider the example shown below of an individual in drawdown for 20 years with a starting balance of $600,000 who withdraws $40,000 p.a. indexed at 2% p.a. In scenario A the investor earns 8% p.a. for 10 years then 4% p.a. while scenario B the return series is reversed. The average annualised return of both scenarios is the same at 5.98%p.a., however the end result for the investor under either scenario is very different given the drawdown that occurs.
For retirees and those approaching retirement, particular attention needs to be paid to minimising downside volatility. One oft-touted solution to the issue of pre-retirement volatility has been life cycle or target date approaches.
Life Cycle/Target date funds
We conducted a historical test of a sample Life Cycle fund vs. a sample balanced fund. Given the significant time horizon required for a historical test (where we need circa 40 years of data for one complete result) we have constructed a basic Life Cycle fund and balanced fund assuming an investment universe of Australian equities Australian bonds, international equities and Australian cash.
Our assumed balanced fund has an asset allocation of 70% equity, 30% defensive. The Life Cycle fund assumes an initial allocation of 90% equity/10% defensive that changes uniformly with age to 65% defensive at age 65. Examining the data since 1900 we can calculate the average annualised return differential between the balanced fund and the Life Cycle option based on the year of commencement and assuming accumulation of contributions over the working career.
In analysing the differences we break the data into two periods – commencement dates for accumulation from 1900 to 1971 and 1972 to 1999. This is based on our assumption that for an individual to retire after 40 years of accumulation by the end of 2010 they would have to have commenced employment prior to 1972. Consequently the start dates 1900 to 1971 represent the full 40 year accumulation period while the dates after that represent only a partial accumulation period. We have not considered individuals who commenced employment in the last 10 years for the analysis as the time period for accumulation is relatively short.
|Balanced fund vs. Life Cycle fund – money weighted (% shows difference in value of accumulated benefit)||1900-1971||1972-1999||1900-1999|
|% of years where Balanced was better than Life Cycle||78%||75%||77%|
|Worst Balanced outcome||-8.2%||-0.8%||-8.2%|
|Best Balanced outcome||58.2%||5.2%||58.2%|
Source: Schroders, Datastream. Based on 40 year accumulation of 9% of salary contributions, indexed at 3% p.a. Bottom three rows represent the actual differential in accumulated benefit over the 40 year period. Positive results mean that the Balanced fund delivered a higher end benefit that the Life Cycle fund and vice versa.
We can see from the table above, the nature of the accumulation process is such that the balanced fund (which is far from the perfect approach) produces generally better outcomes than the Life Cycle option after we take account of the pattern of retirement saving. More importantly, where the Life Cycle fund does come out better, the results are at worst only 8.2% less than the equivalent balanced fund result. On average, the balanced fund strategy resulted in an end benefit nearly 12% higher than the Life Cycle fund.
Only nine times since 1957 has the balanced fund fared worse than the Life Cycle option and even then by only 0.8% on average. Interestingly, the skew is quite clearly to the balanced fund delivering better outcomes than the Life Cycle fund. We would note at this point however that the final results were quite sensitive to the initial asset allocations chosen for both funds, albeit generally the balanced fund option still did comparatively better than the Life Cycle fund once accumulations were taken into account.
In reality, given the path of wealth accumulation and deccumulation, a better representation of the risk profile through time is illustrated below.
To further illustrate this point, the table below shows the effective increase in benefit as a multiple of final salary after 40 years of contributions from a 1% increase in the contribution rate or the earning rate in the first and last 20 years of accumulation.
|% increase in end benefit|
|First 20 years||Second 20 years|
|1% increase in contribution rate||8.0%||3.1%|
|1% increase in earning rate||8.2%||17.8%|
Source: Schroders. 40 year contributions at base contribution rate of 9% of salary, indexed at 3%p.a. Annualised earning base rate 8%p.a.
The above table shows that a 1% increase in contribution rate in the first 20 years will have broadly the same effect as a 1% increase in the investment earning rate in the first 20 years of accumulation. There should be no question that the 1% increase in contribution rate is far easier to achieve than an additional 1% p.a. over 20 years! However, in the last 20 years the situation is considerably different.
Examined another way, we can breakdown the impact on an individual’s total retirement income from contributions and investment earnings in the pre and post retirement phase as follows:
Considering a typical member’s life cycle we can breakdown very simply the key drivers of their retirement income and consequently identify from a fund and advice perspective where the greatest attention needs to be given.
In summary, the most important consideration in maximising post retirement income (for a given contribution rate) is post retirement investment earnings.
Retirees with some level of self funded superannuation assets are typically looking to balance a number of competing objectives, all of which are to some extent mutually exclusive. Further, the tilt towards any one objective will have an impact on all the others. In addition the level of retirees’ non-superannuation assets will play a significant part in determining what the right total solution is for any individual.
In our prior paper2 we detail the trade-offs members face between insuring some of the risks above with respect to longevity and investment (see Appendix for an extract of this section).
The need to balance these competing interdependencies means that an almost infinite number of options could be developed and the potential for complexity is huge. However, funds will need to consider their own requirements for efficiency and balance this with their capabilities. In particular funds will have to consider:
- What is their real “target” membership base for post retirement? That is, will higher balance members likely leave anyway? Are there a substantial number of early retirements?
- To what extent will members require advice and how will funds provide this?
- Operationally, what level of complexity can the fund cope with?
- How much complexity can members cope with, even after allowing for advice? How will this be communicated?
- To what degree should post retirement solutions interact with pre-retirement solutions?
The ideal solution for retirees and funds is therefore likely to be one that:
- fits the greatest number of potential retirees;
- allows for the maximum flexibility for the member in dealing with non-superannuation assets and interaction with the age pension;
- can be tailored with respect to the level of retirement income and the degree of longevity risk the member is willing to take;
- is operationally simple enough to administer;
- can be easily communicated in a scaled way;
- plays to funds current strengths particularly their ability to aggregate assets and offer high quality lower cost total investment solutions; and
- reduces the potential negative impact of poor decision making. In balancing these needs it is our view that the first step for funds should be to offer a range of investment options that allow members to tailor the degree to which they would like to take on investment and longevity risk as outlined below.
The extension for this will be for funds to consider to what degree they want to outsource or offer a form of pooling for the longevity risk component. Given that most funds do not have the capital to support taking on the longevity risk component it would be our view that this is best outsourced in much the same way group life policies are used to outsource pre-retirement mortality risk – at least as a first step in the development process. Larger funds may ultimately want to consider self-insuring some or all of this risk. As such an outline of the member choice framework could look as follows:
The decision then becomes what sits behind these options in terms of investment strategies and in the case of the insured or part-insured longevity risk solutions, the specific insurance details.
A straw-man approach that funds could consider adopting may thus look as follows:
The structuring behind each of these options could then be arranged as:
- Term annuity: Current 5 year Government bond rates are 3.9%, AA 5 year Australian bank bonds circa 5.9%, BBB Australian bonds circa 7%. Funds could either structure a pool of these bonds and adjust rates accordingly so as to diversify credit risk, or offer a lower rate with greater certainty. An alternative would be to use the pre-retirement bond pool to effectively “insure” the post retirement term annuity pool (for a fee).
- Allocated pension investment choices would be non-guaranteed but target CPI linked rates that reflect a margin above where the term annuity rate was set. This would require the establishment of objective based investment approaches targeting these specific outcomes with a specific reference to minimising downside risk (given path dependency considerations). We would add that using structured investment solutions with a heavy reliance on complexity, derivatives or trading strategies to reduce downside volatility is unlikely to be a sustainable cost effective solution. Rather an investment strategy that references embedded risk premia and the downside risk attached to different asset classes that is liquid and transparent is a more appropriate solution.
- While deferred annuities are currently somewhat unattractive from a means test and investment perspective, funds could offer the alternative of grouping members into a pooled post retirement deferred annuity where the final annuity rate was not set until that group of members reached the appropriate deferred annuity age. This would help manage longevity risk (for the fund) and reduce the credit risk of purchasing longer term deferred annuities from the market. The pool of assets backing these deferred annuities should also be invested in a lower volatility CPI linked strategy, with the added potential for the mortality “experience” of the group to be insured or borne by the pool.
- The life annuity option could initially be outsourced to an insurer but with rates negotiated in advance by the fund on a “bulk buy” basis (or in combination with say the group life policy). Funds could look to diversify risk by insurers or unbundle the annuity to better mitigate credit risk of a single insurer.
An approach such as that outlined above would be relatively simple, yet retain the complexity to deal with the myriad of situations likely to be encountered by members. In addition, the expertise and external provider relationships that currently exist within funds would provide significant economies of scale in delivering appropriate post retirement choices (subject to the objective based investment approaches being managed in a different way).
Growth in level of retirement assets in the coming years combined with legislative requirements will necessitate funds establishing a specific set of options for retirees.
Post retirement solutions that are driven off existing pre-retirement approaches are not appropriate given the degree of volatility and the path dependent nature of investors in the drawdown phase.
While most retirees are currently uninsured for longevity and investment risk (age pension aside), full insurance solutions are likely to be too expensive. As such, either better investment approaches for the uninsured or some form of partial insurance model is likely to be most optimal.
The wide variety of external influences on members in the post retirement phase means that some form of flexibility is warranted, however this must be offset against the introduction of complexity. Building options that have a high degree of complexity and target very specific member cohorts is likely to involve spurious accuracy. More generic approaches are likely to offer a better compromise between simplicity, flexibility, the ability to communicate and the funds’ ability to administer cost effectively. In addition such approaches can recognise the likely impediments to providing substantial high quality advice across a wide membership base with in some cases limited assets.
More objective based, outcome orientated portfolios are required to give an appropriate balance of investment and longevity risk for retirees. This will necessitate superannuation funds taking quite a different approach to their investment portfolios than has traditionally been the case in pre-retirement.
Our preferred model for post retirement solutions would be one in which retirees (with suitable transition for pre-retirees) are offered a range of outcome orientated investment strategies (e.g. CPI+2, 3, 4, 5 etc) with appropriate downside risk metrics rather than fixed asset allocation strategies (including Life Cycle and Target Date funds).
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice.
In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us.
Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person.
This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice.
Appendix (extract from Post Retirement – Time to Focus on the Endgame, August 2011)
Options for retirees
The reality for most is that post-retirement income options are generally only considered at or very close to retirement. For these individuals the key options for funding their post-retirement living can be summarised as:
- “Uninsured”. The current situation ignoring the age pension – a traditional investment solution with some form of cash funding to reduce volatility and variable drawdowns (e.g. an allocated pension). However, the retiree bears all the risk of longevity and investment.
- “Fully Insured”. A solution where the investment and longevity risks are fully insured – e.g. an annuity – which may be purchased in aggregate from a life office or potentially provided by a superannuation fund with key elements outsourced to the lowest cost provider of each component.
- “Partial Insurance”. An interim step where part of the investment or longevity risks are insured. Probably the case for many retirees at the moment where the age pension is relevant.
This is the current situation (if we ignore the age pension) where retirees take-on all of the investment and longevity risks.
While at first glance this may seem the most risky option, it should be noted that given the existence of the age pension the downside is somewhat capped in Australia. As such, an argument can be made for retirees that given the existence of a free “put option” from the age pension, retirees are better off bearing all the risks as they get the upside benefits that come from this but limited downside.
While such an approach is clearly valuable when close to the age pension limits, as the potential retirement income stream from superannuation (or other sources) exceeds the age pension by a greater and greater margin, the value of the put option to the retiree declines. At some point it approaches a level whereby the reliance on the age pension would be seen as an extremely adverse outcome and for purpose of this, little real value in determining the strategy to be adopted.
However, from the perspective of the investment outcomes, as we have outlined earlier a focus on “averages” can be very deceiving. In a situation where retirees are bearing all of the risk, the investment outcomes need to remove as much of the unpredictability as possible. This leads us to consider investment solutions that emphasise low absolute volatility of returns and high predictability of real outcomes.
As has already been outlined above, existing pre-retirement strategies do not fare well in this regard. As such, in an “uninsured” world a wholesale change to the investment approach is required, particularly where the age pension “put” is unobtainable or unattractive.
At the opposite end of the spectrum we have the option of fully insuring the life and investment risks through the purchase of an annuity product. At this juncture we consider only full outsourced annuity options. However, in time we would expect to see superannuation funds entering this space. For a given cohort of members it would be possible to build investment solutions with the combination of fully insured longevity risks that are potentially (or almost certainly) cheaper than those provided by a single insurer. To the extent that annuities gain attraction amongst the general populace then for annuity providers this increased awareness and attraction is likely to be their undoing as a product.
As the current custodians of the assets and the member relationship, superannuation funds are clearly well placed to dis-intermediate the existing or future single annuity products. Their success or otherwise in this dis-intermediation will in part be a function of the flexibility of solutions that can be adopted.
In any case, at this stage the principal barriers to annuity provision are two-fold:
- The behavioural biases towards giving up a large lump-sum account balance for an income stream.
- The embedded costs of providing that income stream making annuities appear quite expensive relative to other options.
Our principal issue with full insurance solutions is that insurance works best when you are insuring a lowprobability, statistically predictable, high impact event. (e.g. house fire). However longevity is not low probability. In fact, the probability of one partner from a self funded retiree couple surviving from age 65 to 90 is over 70%. Nor is it that statistically predictable. There are considerable “risks” in longevity. As medical technology advances it is significantly more likely that longevity improves to a greater degree than expected. Any credible insurer will ultimately want to “price” this risk (and if they don’t there is a chance of insolvency which won’t do the purchasers of the insurance much good either – e.g. Equitable Life in the UK).
In addition, retirees take on considerable “credit risk” with the insurer in the case of long term fully insured solutions.
In a partial insurance model longevity “risk” is assumed to be 100% for a particular period (e.g. the first 20 years of retirement) and hence uninsured, consequently becoming an investment risk problem. For the period beyond 20 years longevity insurance is purchased, either at retirement or throughout the working career (e.g. $1 per week for longevity insurance which would go to buying a deferred annuity from age, say 85 or 90).
One could argue that for retirees who plan to self or partly self fund retirement for a period and then fall back on the age pension are in fact adopting a partial insurance model.
While this is analysis for another day, our initial calculations suggest that $1 per week throughout the working career would purchase an annuity from age 85 of circa $20,000 p.a. (in current dollars) (over and above the age pension – subject to the Government making this possible). Interestingly, the most optimal “provider” of such a deferred annuity is probably the Government in that they have the best long term credit rating (relative to private corporations), are already assuming some of this risk in the form of the age pension (and systemically if they were required to bail out a private insurer that went bankrupt), and ultimately could “change the rules” if longevity increases substantially.
The issue with the partial insurance solution then becomes the investment risk assuming that the individual will be required to drawdown their investment for a fixed term.
At its simplest, this could be achieved via a term annuity (also known as a bond). While a 20 year capital drawdown bond could be structured relatively simply by superannuation funds or insurance providers (or indeed the Government as another source of funding), given the time horizons involved and the existence of the age pension floor, some level of investment risk is warranted.
The issue becomes ensuring that the level of investment risk is not excessive as with most existing preretirement solutions. To this end we go back to our original points:
- Current Strategic Asset Allocation driven approaches are not appropriate for retirees in drawdown.
- A significant change is required in the construct of post-retirement investment approaches to focus on the outcome required - i.e.. objective based strategies.
1“Life Cycle Funds – Just Marketing Spin”, September 2011 and “Post Retirement – Time to Focus on the Endgame”, August 2011. Copies of both are available by contacting Schroder Investment Management Australia Ltd (firstname.lastname@example.org or www.schroders.com.au)
2Post Retirement – Time to Focus on the Endgame, August 2011.
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. Schroders may record and monitor telephone calls for security, training and compliance purposes.